Commodity Funds

Mutual Funds and Market Bias

Mutual funds are committed, by regulation, to the long side of trades, and this includes all forms of mutual funds including commodity funds. Should the positions that a fund holds see price increases, all is well, but they are left unable to properly deal with situations which produce declines in price.

The long side of the market is so entrenched into our investing culture that few people think about this too much, as they believe that there is only one side of a trade to ever be on, the long side, and if one thinks that investing and holding mutual funds are one in the same, that is actually true.

Commodity FundsMutual funds and commodities are actually strange bedfellows, because the commodities market in general does not tend toward such a bias, and generally sees both the long and short side of a position as having their place, where one is not favored over the other or seen as being more basic or intrinsic.

There is actually no long or short side of commodities trades per se anyway, at least as far as anything sold short, as one participant stands to benefit if the price goes up and the other benefits if the price goes down. Commodities prices fluctuate in both directions, and over the life of these contracts at least, there is no real intrinsic bias toward one or the other direction.

With some other investments, if one seeks to hold the investment over a very long period, then the pressures of inflation and the stimulus of economic growth will tend to propel its price forward, aside from any excursions in both directions that it may see along the way from changing economic conditions and other factors which influence the price of the investment.

Commodity prices to tend to rise over time from similar influences, but commodity trading doesn’t really concern itself with this, since its scope is of a much shorter duration, usually less than a year in fact.

There aren’t even long term contracts that you can enter in with commodities, and many contracts must be closed out and new ones opened to replace them in order to keep a position alive. The idea of taking a long term position in a commodity is a pretty strange one to commodity traders, both the hedgers and the speculators, and the speculation we see in these markets is measured in periods of months, not years, and certainly not decades.

One need not trade contracts to invest in commodities though, and some commodities can be held for long term periods if one chooses, and the positions that commodity mutual funds seek aren’t the same as a futures trader would.

Futures trading and mutual funds are about as far apart in strategy as one could get, so although commodities mutual funds may seem to be a very strange concept, it can at least make some sense when the commodities themselves are ones that can be held over the long term.

Commodity funds don’t just invest in commodities though, they also invest in the stock of commodity producers, and shares of course can be held over the long term pretty easily.

Commodities Themselves Aren’t Good Long Term Investments

While it isn’t that common for anyone to take a long term view with commodities contracts, some commodities do lend themselves to long term speculation, due to their durability. No one is going to buy and hold commodities like wheat for instance, but with durable commodities like gold and silver, many do choose to hold the metals.

Commodities do not perform as well as more traditional investments like stocks, as they generally suffer from both lower returns and more risk. The idea with investing is to shoot for either one or the other, better returns with more risk, or less returns with less risk, and commodities possess both of the undesirable characteristics and neither of the desirable ones, relatively speaking.

If you compare buying a basket of stocks with investing in precious metals, while we will see periods where the precious metals will outperform the stocks, during bull markets, they underperform the stocks overall.

If the goal is long term capital accumulation, it’s hard to make much sense out of long term commodity investing, at least in terms of what we normally seek from investments, which is the capital accumulation itself.

Why Do Commodity Funds Exist Then?

We may then wonder why mutual funds or mutual fund investors would even bother with commodities, given that their performance tends to be sub-par. If the goal is long term capital growth, wouldn’t it make more sense to go with investments that produce more of this, and why have a fund that is seeking an approach that is essentially inferior in this important respect?

The reason why commodity funds exist is to provide mutual fund investors with a means of diversification apart from the usual stocks and bonds combination that is offered. While stocks and bonds aren’t that well correlated, some commodities like gold are even less correlated, and gold and stocks tend to move in opposite directions a lot of the time.

During major stock market declines, it often makes a lot of sense to move some or even all of your money out of stocks and into commodities such as precious metals, and while the price of most commodities are married to the business cycle in the same way stocks are, precious metals are not.

The main reason is that precious metals, especially gold, have a life of their own apart from their use as business inputs, where other commodities merely function this way. If the economy is in a pullback, less goods will be sold, and the demand for many commodities will decline in turn, but people will take money out of other investments and put them in precious metals.

This is the reason for the inverse relationship between the economy and precious metals, it is all artificial, but if people pour money into them in times of economic downturn, this will indeed be effective in driving up the price of the commodities.

Commodity funds can therefore provide a hedge against bear markets in the stock market, and can even protect against this better than holding bonds would. This is the case whether it is the commodity itself that is held or the stocks of the commodity producer, since higher commodity prices, gold prices for example, will tend to drive up the value of gold mining stocks for instance.

The Need For Hedging with Mutual Funds

If mutual funds moved in and out of stocks and could play both sides of this market the way hedge funds do, or the way commodity traders do for that matter, then it would be pretty easy to hedge against bear markets.

All you’d need to do is get out of the long side when its prospects aren’t so great, and perhaps even look to take advantage of these declines by moving some or even most of your money to the short side, where you can benefit from these declines instead of just taking a beating.

That is not an option for mutual funds though, so they have no real choice but to seek to diversify their positions by placing money in investments that behave differently in bear markets and lesser economic conditions.

So, commodity funds are indeed a hedge, and can serve as a good hedge indeed if investors use them properly, which would be to use them to the extent that a hedge is needed.

While some may argue that due to the unpredictability of markets, holding hedged positions like commodity funds generally may make some sense, but the approach of holding a certain percentage of your portfolio in these hedges regardless of the market circumstances does not.

Mutual funds and mutual fund dealers do not want you deciding anything though, and they have convinced the great majority of their clients that such decisions should be left to the pros, even though these pros may not have the means to manage risk properly.

Using Commodity Funds To Hedge Properly

Ideally, the goal would be to move money into a hedge to the degree that this hedging is needed, and this is the only sensible approach for any hedge actually. So during economic times where hedging would be more needed, one would hedge more, and vice versa.

Mutual funds do have different objectives, and one may track a certain type of stock, another a basket of bonds, and some track commodities. Investors select from among these funds to build a portfolio that corresponds to their investment objectives and risk tolerance.

People don’t generally go all in with commodity funds, at least as far as just holding commodity funds over the long term, and this wouldn’t make much sense anyway. Rather, they may hold a portion of their portfolio in them, to provide some additional diversity.

While mutual funds do not have the means to do anything other than to hold long positions of investments, and therefore are exposed to the full market risk of downturns, this does not mean that investors are limited this way.

If one holds a majority of their portfolio in stocks, long the stock market, and conditions occur where one should pull back from this position and move their money into other assets less exposed to the current risks, then it may be wise to at least consider doing this, and moving to commodity funds to some extent can actually be a good option for those who are reluctant to short, which is the overwhelming majority of investors.

If one is particularly ambitions, one could be short the stock market as well as hold commodity funds during so called bad times, and be long the stock market and short the commodities market during bull markets.

Mutual funds cannot be ever shorted, including commodity funds, but one can invest in inverse commodity ETFs, which take the short side of the commodities market and benefit from downturns in price.

This is well beyond what the majority of investors would ever consider, as they just want to hand over full control of their portfolios to others, and generally do not make any effort to even learn how to manage their own wealth.

This is exactly what the investment industry prefers, as well as the regulators, although individual investors are well served to at least investigate the possibilities beyond just buying and holding mutual funds.

Mixing one’s portfolio with commodity funds can be a good idea to be sure, but an even better one is to use these investments to the degree that they are needed and not just as a once and done fixed percentage which seeks to protect you but does not have the flexibility to do so very well.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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